Liquidation of a Business Under Common Accounting Methods

Liquidation of a business under common accounting methods involves many arbitrary estimates, judgements and assumptions.

If the business is being liquidated by a receiver, an auditor or an accountant, for instance, they must value the shares in the business at their estimated market value. But this value cannot be determined for certain until it has been sold, because the number of potential buyers is limited. It is also uncertain how much time will pass before it can be sold, i.e., how long will it take to find a buyer who will pay that price?

Under these conditions, estimating the net book value of the business’s shares is only an estimate. And because this estimate is necessary to determine if there are sufficient funds to repay any debtors or creditors, any error in this estimate could make it impossible to meet the legal requirements for declaring bankruptcy.

Liquidation of a business under common accounting methods:

• The assets are taken at their historical cost and the difference between that and the net worth is reported as a loss.
• The inventory and other assets are sold and the difference between that and the amount owed to creditors is reported as a gain.

Liquidation of a business under IFRS accounting methods:

• The assets are taken at their historical cost and the difference between that and the net worth is reported as a gain.
• The inventory and other assets are sold and the difference between that and the amount owed to creditors is reported as a loss.

If you were an investor in either company, which liquidation would you prefer?

The point is that a business under common accounting methods is worth what it would cost to replace it with a similar business. And if your business isn’t worth what it would cost to replace it with a similar business, then you should consider replacing it with a similar business.

In other words, if you aren’t operating at least one of the businesses that could take your place — and you probably aren’t, because that would require abilities and resources that are rare — then there’s no reason for you to exist.

The objective of this paper is to explain how a company should be accounted for under the Generally Accepted Accounting Principles (GAAP) as prescribed by the Financial Accounting Standards Board (FASB).

This paper will first describe why a company undergoes an insolvency or bankruptcy. Here, the objective is to explain the event from the point of view of the firm’s creditors and stockholders. Next, it will present how a company can be liquidated under GAAP. This section contains an explanation of how all liabilities from a company are satisfied. Finally, a conclusion that summarizes the entire paper will be provided.

The most common way to record the end of a business is to use the “net asset” method. In its simplest form, that method assumes that any cash in the company when it closes down will be distributed to owners, and anything else will be sold and the proceeds distributed.

That’s an extremely optimistic assumption, and the books of many businesses taken over by their creditors show a lot less than zero. But let’s go with it for now.

Under this assumption, we picture the business as a kind of bag containing money and other assets. When we close down we take out whatever we can get our hands on, and then throw away the bag.

Net asset accounting is simple and transparent, which makes it easy for managers to manipulate. You just have to decide how much unsold stuff you’re going to call an asset. A lot of companies that went under in 2008 used net asset accounting, which is why you see a lot of zeroes on balance sheets these days.

It should be a simple thing to liquidate a business. All the assets are listed, all the debts are listed, you work out how much the assets will sell for and how much the debts will cost to pay off, and the difference is what you get for your ownership share of the business.

There is a difference between the way we talk about liquidation and the way we actually go about it.

We think of liquidation as involving some kind of fire sale: selling off everything and closing down. But the liquidator has an altogether different problem: how to sell off everything without closing down.

For example, if the company is selling things on credit — that is, extending credit to its customers — then taking cash from its customers for those debts is not a sale at all; it is simply discharging the obligation to pay later. The liquidator’s problem is that not only can he not afford to close down, but he also can’t afford to stop selling things.